Alternative investments are hot these days… But what are they, exactly? Broadly speaking, “alternative investments” could mean pretty much anything beyond “traditional” investments in stocks, bonds, or cash. These could be futures, options, commodities, currency carry trades, and a multitude of other specific strategies that yield risk-and-return profiles that don’t fall neatly into the framework of the capital asset pricing model (CAPM), and cannot be fully described through their correlations with the S&P 500. I guess, that’s why they are labeled “alternative” investments.
In my mind, the word “alternative” is not that far from “marginal”, and in real life it seems like many people tend to marginalize these investment options. I don’t know why… Perhaps, it is fear of the unknown, as many “alternative” investment strategies may not be easy to comprehend within the modern seven-minute attention span…
A typical core and satellite portfolio approach involves investing in a “core” passively managed portfolio, and a “satellite” actively managed portfolio. The “core” is typically an index-tracking portfolio whose returns are driven by exposure to specific risk factors. Unfortunately, broad hedge fund index clones, that are currently being sold as “core” risk exposures are not exactly that. As I argued in my previous post, these clones attempt to replicate a mix of “cloneable” and “non-cloneable” funds, i.e. they are in fact “core” and “satellite” portfolios rolled into one product, with no transparency on the exact mix.
Cloning hedge fund indexes with liquid portfolios is hot these days. Major players, including Goldman Sachs, Morgan Stanley, Barclays, Societe Generale, and BNP Paribas, now offer hedge fund index clones. But guess what? These clones underperform the hedge fund indexes they were designed to replicate! The clone sponsors readily admit that, pointing to many technical reasons as to why that is the case (and a recent study by Ben Dor, Jagannathan, Meier, and Xu does a great job in explaining these). However, the most fundamental question is not usually mentioned at all – I mean, why is cloning expected to work in the first place?